Sitting, watching, waiting

Long-only asset managers have been content to sit on the sidelines of European equity markets rather than risk jeopardising the performance they have picked up so far this year. But is there light at the end of the tunnel?

European equity trading activity has been in the
doldrums for the large part of this year. Are portfolio managers shunning
equity market opportunities?

This all depends
on what kind of firm you are. For some asset managers – particularly long-only
houses – opportunities to pick up alpha are few and far between.

Key indices like
the EURO STOXX 50 and FTSE 100 are up 9% and 5.5% year-to-date and the
likelihood of a significant and potentially destabilising macroeconomic event
means it might be more prudent to sit and wait, rather than chase
outperformance at the risk of getting burnt.

According to data
from Lipper, while the average global equity fund gained 5.72% in Q3, it lost
5.2% in Q2.

As such, brokers
have reported a 20-40% reduction in equity portfolio turnover among their
traditional long-only clients, evidence that some portfolio managers prefer to
sit on their hands right now.

Many sell-side
firms reporting anecdotally that US hedge funds and buy-side funds have all but
halted trading into the region.

Then there’s the retail
market. Having put up with years of underperformance in equities, there are
signs that individual investors have begun to lose faith in stocks, opting
instead to look at other asset classes like fixed income.

All sounds a bit grim. What would spark the equity
market back into life?

There seems to be
a growing acceptance among market participants that low volumes are here to
stay for the immediate future.

But given the perilous
state of various economies right now, don't be surprised if a global
macroeconomic event initiates a wave of volatility-induced trading like last
year.

In 2011, a period
of exceptional volatility in August stemming from the combination of the
European and US debt crises was one of the few times since autumn 2008 that
monthly equity trading in Europe surpassed the €1 trillion mark.

Trading also
breached €1 trillion in February 2011, after a brief window of market optimism
at the start of the year.

What kinds of events would influence equity trading
in Europe?

Take your pick
from the potential exit of Greece from the euro, a further slowing down of
growth in China, a reduction in the US budget deficit – the so-called ‘fiscal cliff’
– or conflict between Israel and Iran. Any way you look, it is hugely unlikely
that a positive event will spark equity volumes.

For instance, the
fiscal cliff at the end of December 2012 when some terms of the US’ Budget
Control Act are scheduled to go into effect could lead to a raft of tax
increases and spending cuts.

This may have the
dual effect of reducing US debt and slamming the brakes on economic growth. The
highly partisan nature of the debate is likely to have portfolio managers scratching
their heads as to how it could affect their holdings.

But while such
episodes could reactivate trading, it in unlikely to offer any comfort to single-stock
pickers that could see performance in the equities they select overridden and
nullified by global macroeconomic issues.

Conversely, some
types of quantitative trading strategies could be relying on the outcome of
such events to trigger their strategies.

It’s hard to ignore high-frequency trading (HFT)
given it accounts for around 40% of equity trading in Europe. Can we rely on HFT
firms to continue providing liquidity?

Potentially onerous
regulation in MiFID II and at a national level notwithstanding, decreased
trading volumes combined with low levels of volatility are pretty much the
opposite of what HFT firms need to operate their strategies profitably.

There is evidence
that an unfavourable environment is beginning to take its toll. In September, Virtu, a US HFT firm, bought Dutch market maker Nyenburgh
– suggesting the struggle faced by smaller HFT outfits.

The debate on
whether HFT firms provide ‘real’ liquidity to the market continues, but their
influence within the European market structure may be beginning to wane.